SOCI 215 Final

What are the limits of arbitrage and learning in markets?

Arbitrage can only go so far in creating efficient price -When prices are low, a value investor can buy a corporation outright if they think the value is much higher than the price -When prices are high, there's no comparable strategy (You can sell a stock short, but in the internet boom, there often weren't enough shares to borrow; Short-selling also puts you at the mercy of the speculative market--you'll often go broke before your bet pays off) Learning has its limits in markets -If prevailing theories of value are wrong (e.g., we're in a bubble), then those who recognize this can't do anything to correct it -Since those with the correct theory will simply avoid the market, short-term prices will be set by those with the incorrect theory, so the bubble will just continue to inflate These limitations of learning are rooted in the limits of value-price arbitrage -Bears have few options to express their disagreement with market prices (e.g., The Big Short)

Describe three mechanisms through which cultural capital leads interviewers to hire people similar to themselves

(1) Cultural Fit -Candidates should be similar to a firm's existing workers (leisure activities, background, self-presentation) -Interviewer want to hire people they'll enjoy spending time with, since all of their time is spent at work -Employers hope to minimize turning--people who "fit in" might be less likely to leave (2) Cognitive Processes -It's easier for interviewers to evaluate people who are similar to them (attended the same university, shared past work experiences, same major, etc.) -Individuals construct merit to mean "people who are similar to them" (Interviewer thinks: If I had theses same experiences and I was successful, this person will be, too) -Through this process, firms reproduce the characteristics of their workers: The next generation will look similar to the previous one (3) Emotional Processes -Interviewers hire candidates with whom they feel an emotional "spark" -Emotional connections can overshadow hard differences, allowing interviewers to excuse deficiencies -Along with cognitive processes, emotional mechanisms provide a way for interviewers to sidestep real qualifications and instead hire candidates who are similar to them -Emotional excitement between two individuals depends importantly on shared cultural capital

Describe four mechanisms through which elite universities funnel undergraduates into careers

(1) Lack of information when entering college -Incoming students lack information about all the possible career paths open to them (High expectations and motivation but little concrete direction; Most students know little about finance/consulting) -Lack of information means that campus influences can have big effects (fellow students, student organizations, career-planning offices) -Students learn a ton about careers they never imagined being interested in (2) On-campus recruiting -Recruiting fuels competition for prestigious jobs (Particularly at elite colleges, students are used to succeeding in structured competitions; Investment banks and consulting firms host lavish receptions and have elaborate multi-stage interviews that demonstrate the competition and its rewards) -Finance and consulting dominate recruitment at Harvard (Career center have large numbers of events devoted to applying to finance and consulting jobs, far fewer resources are available for other careers) (3) Social expectations and insecurities about prestige -Elite students feel they must live up to expectations by landing elite jobs (Because everyone agrees that Wall Street jobs are prestigious, getting such a job signals a student's individual worth and success) -Elite jobs are seen as "safe" (Wall Street jobs offer graduates a few years to build wealth, while they hope to later transition to other careers) (4) Status boundaries between good jobs and ordinary jobs -Students learn to distinguish between high-status and "ordinary" jobs (High-status jobs require degrees from elite universities; High-status jobs recruit on campus; High-status jobs have characteristics similar to the most highly visible jobs like finance or consulting)

Exploration vs. Exploitation

-Arbitrage depends on both exploration and exploitation -Exploration means looking for new kinds of associations or ideas that can be used to find innovative arbitrage strategies -Exploitation means recognizing when potential trades fit an existing pattern that the trader knows how to arbitrage -The trading room is a kind of "distributed cognition"'; cognition isn't just a process inside people's heads, it's social and depends on other people and objects in the world (tools, space) -The trading room is designed to foster both exploration and exploitation -Innovation (and the balancing of exploration vs. exploitation) challenges traditional views of cognition as calculative maximizing before one begins to act -It's impossible to calculate the tradeoff between exploration and exploitation; instead, traders learn as they go, continuing with strategies that work and searching for new ones when they see evidence that the strategies are becoming less effective

Two types of mortgage risk

-(1) Default: The mortgage holder fails to make payments -Someone defaults on a mortgage if they (1) can't make their mortgage payments, and the bank takes their house back or (2) If the price of the house decreases so that its worth is less than the balance remaining on the loan, the borrower will likely walk away from the loan -Default was not a risk in the 1980's: Mortgages required buyers to meet high credit standards, and loans were guaranteed by the government, so lenders wouldn't lose the principal -The idea of pooling risk into mortgage bonds meant that investors had a new way to protect themselves against mortgage default, even if the loans weren't backed by the government -When teaser rates began kicking in around 2006-2007 after homeownership had peaked in 2004, borrowers began to default, all at once, because they couldn't make payments or because their mortgage was underwater -People before the 2008 Financial Crisis held the assumption that defaults weren't correlated, even though they were, which resulted in massive losses -(2) The mortgage holder repays their mortgages too quickly, so the "investment" ends too quickly for the mortgage seller -1980's: Biggest fear was that homeowners would repay their mortgages too quickly (Solution: Divide the mortgage bonds into tranches) -Before subprime mortgages, the key risk of investing in a mortgage (or mortgage bond) was prepayment -Prepayment risk in early mortgage evaluation remained the key worry even after subprime mortgages came into being

Describe three consequences of the end of managerial capitalism (for corporations or for workers)

-(1) In terms of leadership in corporations, managers shifted their priorities to the stockholders, rather than placing the workers, customer, or great community as their priority -(2) With the institution of shareholder value, pension plans for retirement were essentially eradicated, and there was a shift to individual retirement plans invested in stocks (Key provider of economic security shifts from big corporations to the stock market) -(3) The end of Managerial Capitalism meant that corporations would now be viewed as a nexus-of-contracts, which asserts that if the value of all the individual pieces of a corporation is greater than what of the whole (intact) corporation, it would be profitable to split it up and sell off the pieces (this ended diversified conglomerates and brought forth the hostile takeover movement)

Why did opportunism thrive in bond markets in the 1980's?

-(1) No face-to-face relationships (The bond market is over-the-counter, so trades happen through computers or over the phone, often through intermediaries; This creates only a weak reputational network, which makes it harder to enforce norms) -(2) Traders are separated from their customers by the sales force (Traders may feel bound to one, another, but they feel little obligation to either salespeople or to their customers) -(3) The most opportunistic firms often provide the most profits, so customers accept some degree of opportunism -(4) Traders believe that customers expect them to be opportunistic, but customers can't predict which trades they'll get cheated on

Why did corporations shift towards large, diversified conglomerates in the 1960's and 1970's?

-1950's and 1960's brought growing concerns about oligopolies (spurred in part by concerns about national defense); New antitrust legislation made it more difficult to grow within your own industry (by buying competitors and suppliers) -Diversification became the only path to growth (Multi-divisional organizational structure ("M-Form") provided a way to manage these new entities, further concentrating power among managers) -If takeovers bring efficiency, and corporations are just sets of contracts, then we should open up the takeover market and break up the large, diversified conglomerates that had come to dominate the 1970's -Shareholder value provided an institutional rationale for breaking up conglomerates, and the corporation-as-a-nexus-of-contracts provided a new set of cognitive categories to make sense of corporations (The desire to break up the conglomerates unleashed a new wave of financial innovations that led to the hostile takeover movement of the 1980s and solidified the era of shareholder capitalism)

Leveraged Buyout (LBO)

-1980's innovation: Junk bonds and the leveraged buyout (LBO) -LBO's were typically funded by junk bonds -An LBO is the acquisition of another company using a significant amount of borrowed money to meet the cost of acquisition; the assets of the company being acquired are often used as collateral for the loans, along with the assets of the acquiring company -An LBO is when you buy another company using mostly borrowed money (i.e., "leverage": $1 in investment is leveraged into $20) -Raiders buy the company with debt (using the company they're about to purchase as collateral), then sell off pieces of the company and lay off workers to pay off the debt (Raiders often contribute only a very small amount of equity (e.g., 1% in a $100 million deal), but they capture all the profits (minus debt financing) because bondholders don't get equity) -Acquired corporations were often saddled with huge debts, and many of them failed (bankruptcy) after acquisition -Example: The Safeway LBO (CEO Peter Magowan teamed with private equity firm KKR to buy Safeway themselves; Magowan promised no layoffs or restructuring, but after the deal laid off 63,000 workers, sold off many whole divisions, closed half its stores, and cut hours and wages to remaining employees); Safeway was left with $5.75 billion in debt; the deal, however, brought huge profits for banks ($65 million in fees), lawyers/accountants ($25 million), Magowan and Safeway executives ($28 million with another $100 million in stock options four years later); KKR also netter its investor ground $700 million off a $2 million investment in capital -Michael Milken and Drexel Burnham Lambert popularized junk bonds and the LBO

Collateralized Debt Obligation (CDO)

-A CDO is a complex structured finance product that is backed by a pool of loans and other assets and sold to institutional investors -A CDO is a particular type of derivative because, as its name implies, its value is derived from another underlying asset and these assets become the collateral if the loan defaults -Essentially, a CDO takes a bunch of mortgage bonds (or other CDO's), slices them up, and repackages them together to pool the risk -CDO's containing nothing but BBB-rated bonds could be packaged together, and the ratings agencies (whose fees are paid for by banks, often only if they deliver a satisfactory rating) rated them as AAA or AA -CDO sales represent one challenge to the EMH; banks and ratings agencies didn't really use all the information available to them about the underlying mortgages to rate and price them; as a result, information was willfully obscured from investors, and investors didn't care -In the case of CDO's, firms learned superstitiously: They followed what was popular, especially what was popular among firms with rising share prices (Outsiders don't know whether CDO's were responsible for the share-price increase or whether there were any real profit benefits, but share price is the only signal they have to follow) -Since CDO's and synthetic CDO's package and repackage the underlying mortgages repeatedly, it was almost impossible for investor to figure out what loans were inside them and how much subprime risk they were exposed to -The first CDO's were built from corporate debt; corporate bonds had no risk of prepayment, so CDO's were aimed at pooling the risk of default -CDO's were created by derivatives teams within investment banks, not by securitization or corporate-debt groups -The basic principle behind CDO's is arbitrage: Buying a product on one market and then selling it (often instantaneously) on another market at a higher price, creating guaranteed profit -Corporate CDO's took high-yield corporate bonds (with lower ratings) and packaged them into low-yield (but safer) CDO's (this was the trick of turning BBB bonds into AAA CDO's) -ABS CDOs (CDOs made up of mortgage bonds or credit default swaps on mortgage bonds) were created later and modeled on corporate-debt CDOs -ABS CDO's were essentially pools of pools of risk; they packaged together mortgage bonds that had already eliminated idiosyncratic risk, so there was no risk left to diversify away -Dot-com bust (2000-2002) caused investors to flee corporate debt, and they saw mortgage-backed (ABS) CDO's as the place to go -All three ratings agencies gave CDO units (not mortgage-securitization units) responsibility for rating ABS CDO's; raters of ABS CDO's relied on risk estimates for the underlying mortgage bonds already produced by securitization (ABS) teams; this meant using pooled models that needed aggregate estimates of correlations--data on the underlying individual mortgages weren't needed or used -The difficulty of measuring and modeling correlation meant that it was central to CDO analysts and largely ignored by ABS analysts (Ontologies) -The two-step rating procedure that used ratings of ABS groups and left responsibility to CDO groups to rate the overall ABS CDO was the result of a particular organizational structure -ABS CDOs were built to take advantage of separate evaluation practices for mortgage bonds and for CDOs carried out by separate groups

Asset Bubble

-Asset bubbles are widespread, and these are periods when prices are far higher than intrinsic value, but that difference doesn't get arbitraged away -Asset bubbles persist because investors believe that everyone else is going to continue to overprice the asset, and it can be hard to bet against the market over a long time horizon -EMH asserts that we should do nothing when faced with an asset bubble because the market is self-correcting (pure constructionist perspective shares the implication that there's nothing investors can do if prices diverge from value) -Financialization was driven by asset bubbles in the 1980's, 1990's, and 2000's that brought more and more resources to financial markets -Investors become overconfident during periods of growth, and their belief that asset prices will continue to rise becomes a self-fulfilling prophecy -Credit standards deteriorate as investors look for new sources of capital to invest, leaving the broader economy vulnerable to the bursting of the asset bubble

Mortgage bond

-A mortgage bond pools thousands of individual mortgages into a single security, and the investor gets the cash flows from all of them (pools of mortgages that aim to spread out risk) -In the 2000's, there was an insatiable demand of the bond market for more mortgage bonds -A Credit Default Swaps (CDS's) provide a way to bet against mortgage bonds because a CDS is essentially an insurance policy o a mortgage bond--the buyer makes small payments, and the seller pays the full value of the assets in the event of a default -Collateralized Debt Obligations (CDO's) take a bunch of mortgage bonds (or other CDO's), slice them up, and repackage them together to pool the risk -In the event of default, mortgage bondholders could sell off the underlying property to compensate for the default and secure payment of dividends -Diversification was the main justification for creating both mortgage bonds and CDO's; pooling lots of mortgages eliminates "idiosyncratic" risk (risk particular to a particular mortgage) and leaves only "systematic" risk (risk faced by all assets, like macroeconomic conditions) -Mortgage bonds already eliminate idiosyncratic risk by pooling lots of separate mortgages -ABS CDO's (CDO's made up of mortgage bonds or CDS's on mortgage bonds) were built to take advantage of separate evaluation practices for mortgage bonds and for CDO's carried out by separate groups -After the 2008 Financial Crisis, mortgage bonds and CDO's became worthless, causing the government to propose a $700 billion bailout package to buy them all up

Network

-A network is the combination of all the people you know, all of whom influence your behavior and actions and enforce social norms -Networks carry certain influences along with them that impact you heavily, such as fads, fashion, language, job leads, etc. -An example of a network would be a collegiate athlete because they're connected to a unique group that can include other student-athletes, coaches, trainers, role models, etc.

Distributed Cognition

-A process in which two or more learners share their thinking as they work together to solve a problem -The trading room is a kind of "distributed cognition"' -Cognition isn't just a process inside people's heads, it's social and depends on other people and objects in the world (tools, space) -This was seen with CDO's and ratings agencies: How securities are evaluated depends on social factors, like how organizations divide assets to be rated among groups and on the distinct tolls used by each group

How did the organizational structure of ratings agencies contribute to the miscalculation of risk when they rated CDO's?

-A second key factor also brought about mezzanine CDO's: -The two-step rating process where securitization groups rated the mortgage bonds and then derivatives teams rated the CDO's -Different parts (teams, departments) of organizations typically have their own routines and practices -The birth of ABS CDO's forced a decision about which group to task with their analysis -The two-step rating procedure that used ratings of ABS groups and left responsibility to CDO groups to rate the overall ABS CDO was the result of a particular organizational structure

How do speculative bubbles (like the housing bubble) come about?

-A speculative bubble is usually caused by exaggerated expectations of future growth, price appreciation, or other events that could cause an increase in asset values -This speculation and resulting activity drives trading volumes higher, and as more investors rally around the heightened expectation, buyers outnumber sellers, pushing prices beyond what an objective analysis of intrinsic value would suggest -Subprime mortgages grew and grew to try to meet the insatiable demand of the bond market for mortgage bonds -Growth depended on finding more and more people to take out home loans, which resulted in (1) credit standards falling lower and lower and (2) mortgage lenders creating complicated conditions that borrowers often didn't understand (teaser rate) -The rapid growth of new homeowners outpaced the rate at which new homes could be built--demand outstripped supply (Housing prices went up and up and up, with no end in sight)

How are mortgage-backed CDO's a form of arbitrage?

-ABS CDO's (CDO's made up of mortgage bonds or CDS's on mortgage bonds) were created later and modeled on corporate-debt CDO's -Lower tranches of mortgage bonds offered even higher yields than similarly rated corporate bonds, which created an even larger arbitrage profit opportunity -2000-2002 dot-com bust caused investors to flee corporate debt, and they saw mortgage-backed (ABS) CDO's as the place to go -ABS CDO's--pools of pools of risk--were packaging together mortgage bonds that had already eliminated idiosyncratic risk, so there was no risk left to diversify away -When more than one group is evaluating some instrument (security), it creates arbitrage opportunities when those groups evaluate them differently -ABS CDO's were built to take advantage of separate evaluation practices for mortgage bonds and for CDO's carried out by separate groups

Three Kinds of Status

-According to Max Weber, there are three kinds of status: Class status (material resources like money), social status (prestige), and power -Status is often tied to social roles (occupations, etc.) -Status provides one mechanism for social closure (status groups create insiders, who have access to resources that aren't available to outsiders (monopolization, exclusion); market power (and cartels) are another example of social closer) -Banks vie for status among one another (and as a group in opposition to corporate America), and students vie for status in universities and jobs -Organizations use status to make decisions because status reduces uncertainty by simplifying decisions and provides an easily reproduced blueprint for all kinds of domains (Status alleviates the need for organization to make hard decisions, such as not being sure who to hire, since they can just hire the person with the highest status)

The gender pay gap

-Across the board, women earn less than men in the U.S. (women earn 79% as much as men for full-time employees) -Louise Roth found that women earned 29% less than men in elite Wall Street jobs despite working in the same departments, holding the same titles, etc. -The "average" job has a gender pay gap of 10%, which is much less than the 29% gender pay gap on Wall Street

Institution

-An institution is a widely adopted and persisting norm, custom, or convention that's enforced in society through laws, rules, tradition, or social pressure -Institutions have become the foundation to our culture and provide us with behavioral scripts that are widely adopted -An example of an institution is how people around the USC campus will say "Fight On!" to each other and hold up the victory sign as they pass by each other. This has become categorized as an institution because it's such a widely adopted norm/custom around the USC campus

Four Shareholder-Value Solutions

-Board Independence: Shareholders (not managers) elect board of directors, boards choose executive leadership, managers who fail to obey the market can be replaced without their consent (managers attempted to defend themselves with "golden parachutes") -Executive Compensation: Executive leaders' salaries were tied to stock price, growing share of compensation comes from stock options, most straightforward way to solve the principal-agent problem (How do you convince managers to act in the interests of the owners instead of in their own interests?) -Market for Corporate Control: Low stock prices create incentives for outsiders to buy control of the company and improve its management, control of a company is an asset that can be bought and sold; barriers to an active takeover market: Corporate size and Antitrust laws -Outside Accountability: SEC added stricter rules for accounting (outside accountants audited corporate financial records so that shareholder knew the truth of what was happening inside a company); financial analysts grew as a job in investment banks, ratings agencies, and institutional investors; stock exchanges created strict standards for listed companies to ensure transparency

How do investment banks and investment bankers maintain their status in relation to corporate America?

-Both Wall Street and corporate America focus on shareholder value, which can spur layoffs -Because Wall Street aims to position itself as being one with the market, it follows short-term shifts much more quickly than corporate America does -As a result, Wall Street assumes maintains a superior image in relation to corporate America because of its (1) "flexible" and (2) "adaptive"

How have investment banks pushed the bulk of their downside risks onto their workers and onto the state?

-By profiting on deals themselves, not the success of those deals, and by paying bonus-heavy compensation that can be cut at any time, banks reduce their downside risk -In times of recession, there are fewer deals to be had, so banks do suffer, but they're largely insulated (Recessions also create their own deals--lots of corporate restructurings and bankruptcies; The need for these other investment-banking products during bad economic times further shields banks themselves from market downturns) Banks are like casinos: -Banks do even better than casinos -They make transaction profits on every deal done -But they also invest heavily in the market and achieve big gains when the market does well, so they capture all the upside risk -By putting themselves at the center of global financial markets, they often become "too big to fail", so they command government support and bailouts in times of trouble -Banks successfully pushed downside risk off to the government (and to their workers)

How do futures markets act as cartels?

-Cartel: A group of producers who cooperate to restrict trade (often fix prices, limit supply, etc.) -Futures markets are a site of "free" competition, which is a carefully organized, artificial social arrangement -Futures markets act as cartels that police their boundaries and ensure that fair competition exists within those boundaries while eliminating competition from outside them -Example: Bucket shops were essentially bookies for futures speculators: People could go to bucket shops and gamble on the price of futures without participating in trading on the CBOT -Bucket shops were dangerous to the CBOT because they (1) Took commissions away from CBOT traders, (2) Reduced liquidity in the pit, and (3) Led the public to equate futures trading with gambling -CBOT acted as a cartel by winning a series of Supreme Court decisions affirming its right to restrict the dissemination of its prices, viewing them as private property

Cognition

-Cognition is a way of viewing the world from a certain perspective -However, cognition isn't universal "human nature", but rather something that varies across social contexts -Sometimes when there are no well-developed scripts (or you don't know the script), cognition provides the tools to guide your non-routinized behavior -An example of cognition is how in Native American tribes there are always elders that spread knowledge and stories to the younger members of the tribe. From this tradition, the ancestors influence the younger member's cognition with their opinions mixed into the stories and traditions they share.

Normal Accidents (Charles Perrow)

-Complex systems create situations where no amount of planning can prevent inevitable errors and failure -Catastrophes can come from organizational design—organizations use technology more complex than they can understand, and catastrophes aren't the result of individual human errors but rather result from the organization of the whole system -Contributors to normal accidents: (1) System complexity, (2) Tight coupling of system components, and (3) Potential for catastrophic failure -Accidents in modern, complex technological systems (like nuclear reactors) are "normal" and should be expected, because we don't have the organizational tools to prevent them

Cultural Capital

-Cultural Capital: Includes an individual's language/speech; style of dress; habits; codes of behavior; tastes for and knowledge of art, music, etc. -Activities that aren't immediately useful often have value as cultural capital (Latin, poetry, musical instruments) -Noneconomic factors that mark an individual's class status -Acquired from parents, peers, and education -In everyday life, such factors are often treated as measures of individual ability rather than as a reflection of class and education -Rich people play polo because it has high barriers to entry, such as the need for horses, lot of land, and knowledge of an activity that comes primarily from other wealthy families -Cultural capital shapes individual aspirations: What kinds of education and careers are desirable (or even possible) -Cultural capital affects how individuals judge one another in everyday interactions (Americans rate people with higher cultural capitals as more competent, more likable, and more trustworthy) -Cultural capital helps to define what we mean by "merit"

Explain this statement: If all investors believe in the EMH, the market cannot be efficient

-EMH is weird: In order to be predictive, it requires limited, not complete, adoption by investors -If prices reflect all available information, then there's no incentive for anyone to collect information, and markets will be less efficient as a result -If all investors assume that arbitrage is irrational (because prices already reflect true value under EMH), then no one will engage in arbitrage, and the market loses its mechanism for bringing prices in line with values -Arbitrage profits would only be available to investors who don't believe in the EMH -If all investors believe in the EMH, the market cannot be efficient -The EMH is, in a sense, self-defeating, not self-fulfilling

Efficient Market Hypothesis (EMH)

-Efficient Market Hypothesis (EMH): Prices of securities represent the best estimates of their discounted future value stream (Stock prices must be an accurate measure of corporate performance) -Prices respond immediately to new information -Prices are "correct" in that they properly incorporate all available information -According to the EMH, stock prices follow a random walk in continuous time (huge disputes about this at the time, which forms the core of the EMH); index funds were created in response to random-walk theories of financial markets -Financial markets function as prediction markets: Future expectations are reflected in current prices -EMH implies that it's impossible for an investor to out-perform the market in the long-run (Warren Buffett disproves this) -Investors can't beat the market by trading on public information, because any profit opportunities should already have been incorporated into current market prices (Any investor who disagrees is ignoring the existence of arbitrage and learning effects) -If the EMH is true, it means that managerial decisions in corporations are rewarded or punished quickly, so stock price provides managers with a signal on how to behave -EMH also provides justification to urge regulators to eliminate any impediment to market efficiency -If share price provides the best estimate of future profits (according to the EMH), then companies maximize social welfare by maximizing their share price -The development of the Capital Asset Pricing Model (CAPM), which shows how to quantify the tradeoff between risks and expected returns, and early forms of the EMH provided a clear way to model stock prices -CDO sales represent one challenge to the EMH because banks and ratings agencies didn't really use all the information available to them about the underlying mortgages to rate and price them; information was willfully obscured from investors, and investors didn't care; CDO's spread as a contagion, not because each bank was acting rationally on its own

Embeddedness

-Embeddedness (Granovetter): Economic action is embedded in social structures--concrete personal relationships (networks) that help to generate trust -Example: Market makers are embedded in multiple, overlapping communities operating at different institutional levels (e.g., banks, stock exchanges, groups of other market makers) -Example: Market making is different on the NYSE, the CBOT, and in bond markets, because market makers are embedded in different social contexts

Explain the formula that "to arrive" contracts + standardized grading = futures markets (To do this, you should define both "to arrive" contracts and standardization)

-Fast prices brought by telegraphs would've been useless in a sack-based wheat system, because samples traveled much more slowly than prices (CBOT system of wheat grading solved this, allowing wheat to be traded over telegraph, well ahead of its delivery; This created the "to arrive" contract for wheat) -"To Arrive" Contracts: Eliminated uncertainty about wheat prices for farmers and shippers...But opened the door to speculators willing to absorb the risk of price uncertainty (Speculators could now sell grain they didn't own--"selling short"--hoping that the price would decrease before delivery) -When the CBOT was founded in 1848 to oversee Chicago's commercial activity, wheat production exploded in the mid-1850's thanks in part to export growth caused by the Crimean War in Europe (Growth brought about a large market for wheat centered a the CBOT) -Standardization: CBOT used its new power to standardize grain in Chicago, designating three categories of wheat (white winter, red winter, and spring); Unintended consequences: CBOT wasn't doing this to solve the problem of sacks -1865: CBOT follows the same path as in wheat quality standardization and standardizes futures contracts: Size, grade, and delivery dates (Futures contracts became interchangeable and could be bought and sold independent of physical grain; Contracts didn't have to be delivered: On the delivery date, buyers and sellers could simply settle based on the difference between the contract price and market price) -Standardization made futures markets possible, but it also made corners possible (after 1865) -Without grades, the wheat supply is too large to feasibly corner

Finance Capitalism

-Finance Capitalism (1890's-1920's): Wall Street bankers created and maintained ongoing influence on the management of the largest corporations -Bankers led mergers of many local and regional producers into national monopolies and oligopolies (General Electric, US Steel, International Harvester, AT&T) -Bankers dominated boards of directors and continued to exert strong control over corporate policies -Big corporations brought public mistrust, who feared anticompetitive practices ("Trust-busting": Sherman Antitrust Act of 1890 and Clayton Antitrust Act of 1914) -Under finance capitalism, corporations had cynically implemented employee benefits to improve public opinion

How has financialization contributed to U.S. income inequality?

-Financialization shifts money away from workers and production and into financial activities and financial markets -Decrease in production-related investments, which stagnates non-financial growth -Fewer resources were now available for non-financial (non-elite) workers -This also means that owners' and elites' bargaining power is strengthened relative to workers, and workers now get excluded from the bargaining process -Financial income is independent of production workforce -Perhaps this explains the decoupling of wages and productivity: Workers are more productive, but profits get directed elsewhere -Institutional Shift: Finance is now more culturally valued in the U.S. than ever before (e.g., the portfolio society) -Increased status of finance makes it easier to justify high wage concentration -Meanwhile, low-wage work has been further devalued, especially with the shift from manufacturing jobs to service jobs -Greater financialization in industries decreases labor's share of income (Financialization accounts for more than half of the decrease in labor's share of income since 1970) -Financialization increases top executives' share of income (In part, this is because managers are the ones rewarded for their perceived success in promoting shareholder value, which increases their bargaining power since their wages are set by boards of directors) -Financialization increases earnings dispersion among workers (Differences between the top and bottom get wider, including a greater wage difference between college-educated and non-college-educated workers)

Financialization

-Financialization: The growing importance of financial activities as a source of profits in the economy (not just financial firms but also profits for non-financial firms) -With financialization taking place, there was a decline in manufacturing and an increase in services (in terms of relative industry shares of U.S. employment, GDP, and corporate profits) -The ratio of portfolio income (interest, dividends, and capital gains) to cash flow for non-financial firms greatly increased, but dipped slightly between 1995-1998 -Financialization isn't (1) distinct from deindustrialization (shift to service jobs), (2) financialization isn't the same as the growth of innovation in financial instruments, (3) financialization isn't about political/economic power of the 1% (but financialization might overlap with all these things) -Financialization was caused by (1) speculative bubbles, (2) shareholder value, and (3) phases of capitalist development (Marxist view) -Speculative Bubbles and Financialization: -Financialization was driven by asset bubbles in the 1980's, 1990's, and 2000's that brought more and more resources to financial markets -Contrary to the EMH, speculative bubbles are inherent to financial markets -Investors become overconfident during periods of growth, and their belief that asset prices will continue to rise become a self-fulfilling prophecy -Credit standards deteriorate as investors look for new sources of capital to invest, leaving the broader economy vulnerable to the bursting of the bubble -The state's role is to stabilize, though this can worsen crises (e.g., if financial institutions know they'll be bailed out) -Problem: This doesn't explain why financialization took off in the 1980's and not earlier -Problem: This treats the state as an outsider to markets -Shareholder Value and Financialization: -Financialization was caused by the shareholder-value revolution, which oriented firms towards financial markets -Regulation played a key precipitating role, first as antitrust restrictions led to the rise of the diversified conglomerate, then when Reagan relaxed restrictions that enabled both junk bonds and hostile takeovers -Explains why even non-financial firms shift towards financial markets -Problem: Still treats state policy as an outside, enabling force and doesn't examine why state officials weakened antitrust restrictions or promoted macroeconomic policies that encouraged finance -The Marxist View of Financialization: -Capitalist development alternates between "material expansion" and "financial expansion" -Post-World War II expansion in the U.S. was driven by the creation of the vertically integrated, multinational corporation (But this stagnates as other countries like Germany and Japan copy the U.S. model and compete for the same profits) -Solution to stagnation: Firms to shift resources to financial markets instead of investing in production -The state played a key role in this shift, building up huge debts that fuel the growth of the financial sector -Problem: Assumes that government officials and business elites work together seamlessly towards to same goals -Problem: Explains how the state solved firms' crisis in declining profit but not the broader crises facing the state -Financialization as State Response to Crisis: -State policies were at the heart of financialization, increasing interest rates and dramatically expanding credit in the U.S. economy in the 1980's and subsequent decades -In the post-World War II period, thanks in part to the dominance of Keynesian views in macroeconomics, the state played a central role in managing the economy and its social consequences -The declining economy of the 1970's ended the postwar expansion and created a series of crises for the state (Social Crisis, Fiscal Crisis, and Legitimation Crisis) -A key contributor to financialization was the removal of interest-rate restrictions (interest-rate deregulation fueled financialization) -The state didn't intend to produce the shift to financialization (financialization was the unintended result of the state's attempts to resolve the social, fiscal, and legitimation crises it faced in the late 1960's and early 1970's); these solutions just kicked the can down the road, fueling the boom-and-bust cycles of the 1980's, 1990's, and 2000's -Five pressing social problems resulting from consequences of Financialization: -(1) Less mobility, more inequality -(2) Educational insecurity -(3) The end of the corporate safety net -(4) Dangerous (and poorly regulated) financial services -(5) Brain drain from government to contractors

Name at least three arguments that proponents of electronic trading made against open-outcry (pit) trading, and explain how pit traders responded

-For 150 years, the CBOT relied exclusively on open-outcry trading in pits -Futures trading happens in open-outcry pits that look chaotic and self-organizing -Open-outcry trading happens in the context of strict rules that are both formal and informal; Rules are created and enforced by social relationships and organization arrangement (of power) -(1) Lower Costs and Fees: -Electronic trading promises to eliminate many commissions and fees, giving customers cheaper access to trades (Electronic trading also promises tighter bid/ask spreads, so customers pay less to complete trades) -Pit traders argue that their fees are valuable, because they play a valuable role in preserving market stability, liquidity, and trust -(2) Faster Trades: -Much like the introduction of the telegraph, electronic ordering dramatically speeds the task of carrying out a trade -Pit traders argue that hybrid systems can take advantage of this, too (Even this has a strong element of network-backed power: Traders want to preserve trading but allow electronic systems to take the place of clerks, runners, and back-office staff) -(3) Ease of Access: -Electronic markets open trading to anyone with a computer -Pit trading is dominated by old family networks and is geographically concentrated in places like Chicago -Electronic trading turns out not to be so equal (e.g., HFT and other examples) -(4) Greater liquidity: -Electronic markets promise greater liquidity by increasing the number of traders in the market (making the market global) -Pit traders say that Chicago markets are famous for providing liquidity because the pit provides speculators (and market makers) who will always trade -(5) Reduced cheating -Electronic markets argue that massive electronic surveillance makes it easier to catch cheaters -Pit traders argue that market manipulation (and opportunism) is easier to carry out in anonymous electronic trading -Pit traders have daily face-to-face relationships, and this provides a strong mechanism for generating trust and transparency

Post-Industrial Society

-For most of the 20th Century, American society was organized around large corporations: industrial society -In the 1980s, American society began to shift so it was organized around finance: Post-Industrial Society -Decline in manufacturing jobs, replaced by an increase in service jobs -Decrease in stock ownership -Shift from pensions to individual retirement plans invested in stocks: Key provider of economic security shifts from big corporations to the stock market -Lifetime-employment model replaced by a society of shareholding free agents -The changes made in the 1980's provide further reinforcement for elevating shareholder value to the top of our social priorities

Frames

-Frames: The set of cognitive assumptions, categories, and tools that someone uses to understand something in the world -Different groups have different cognitive frames (e.g., two key frames used by the Federal Reserve: Macroeconomics frame vs. "finance and banking" frame) -Frames: "Principles of organization which govern subjective meanings we assign to social events" (Goffman) -Frames are cognitive structures that people use to interpret social life -Frames aren't just inside people's heads; they're institutionalized structures that must be maintained through social interaction over time (much like norms) -Frames make some interpretations of events likely and other interpretations less likely (Frames shape how we filter information--what do we pay attention to and what do we ignore?); compare the "prepayment risk" vs. "default risk" frames we saw inside ratings agencies (MacKenzie) -Bounded Rationality means that our brains can't possibly have complete information (we can't look at absolutely everything) -Frames help filter out all the information we deem as unnecessary, but they consequently create blind spots in the process -Frames enable consensus within groups (they're useful) -The professional backgrounds of FOMC members shapes their frames: Professional bankers were more likely to adopt a finance and banking frame, while economists whose research focused on macroeconomics adopt the macroeconomics frame -FOMC was dominated by a set of macroeconomists who all had the same frame, particularly the new neoclassical synthesis -FOMC members with a macroeconomics frame discounted the possibility that financial markets can have real impacts on the broader economy -The macroeconomic frame caused the FOMC to ignore the importance of financial markets and to treat any signs of danger as self-correcting -It's hard to have a diversity of frames while still allowing consensus to form, and the FOMC is historically based on consensus -FOMC members with finance/banking backgrounds were more attuned to crisis, but macroeconomists still have most of the power within the Federal Reserve

Homophily

-Homophily: The tendency for people to seek out or be attracted to those who are similar to themselves; People like other people who are similar to them -The most common mechanism interviewers use to assess candidates is similarity, or Homophily -Homophily between managers (here, same gender) and workers and among managers lead to better performance evaluations (Castilla 2011)

The fundamental problem of corporate governance

-How do you get accountability and control when you have widely dispersed ownership? -Principal-Agent Problem: Managers (Agents) make the decisions that affect the profits of owners/shareholders -The Principal-Agent Problem leads us to the fundamental problem of corporate governance: How do you convince managers to act in the interests of owners instead of in their own self-interest?

The social construction of merit

-How societies think about merit changes over time (Who is the best? Who is deserving or undeserving?) -One constant through time: Merit is defined to reflect values, tastes, and characteristics of elites (elites occupy positions of power, so they can set the rules of the game to reward people like themselves) -Ideas about merit are shaped by power struggles (e.g., college-admissions standards shifted in the 1920's in an effort to exclude Jews)

Human Capital

-Human Capital: An individual's skills, knowledge, and educational resources—it's the product of "investment" and determines how much an individual can produce in the labor market -Human capital struggles to explain phenomena such as elite hiring, where many factors beyond education matter -Economic, social, and cultural capital can be seen as an alternative

What key developments were necessary for high-frequency trading to succeed? (Hint: Talk about how Reg NMS combined with market fragmentation to make speed important)

-In 2004, more than twenty specialists on the NYSE were accused of "front-running" their customers -Fear of front-running led to new market rules: Reg NMS, requiring brokers to execute orders at the "best price" (replacing an older, vague standard of "best execution") -Reg NMS set up the National Best Bid and Offer (NBBO) system, which defined what the best price was -NBBO was implemented via the Securities Information Processor (SIP), which aggregated prices from every different stock exchange to determine the current market price -Reg NMS was designed to create equality of opportunity in the market and prevent front-running -Instead, Reg NMS changed the landscape in a way that gave big advantages to traders who could operate more quickly (HFTers) -In the old days, it was just the NYSE, then NASDAQ entered the market -By 2007, there were 13 different stock exchanges, and most of them processed trades on all the same stocks (there was also dark pools that sold access to their orders to HFT firms, essentially allowing them to become individual exchanges) -Instead of 13 different exchanges, there was actually 80 now -Since Reg NMS forces trades to be filled across multiple exchanges, HFT firms can now see trades on one exchange and then try to beat the rest of the order to other exchanges -The proliferation of exchanges allowed HFT to have great success

The Portfolio Society

-In the portfolio society (ownership society, investor society), individuals treat everything in their social lives as investments: -Education and jobs are human capital (What kinds of skills should you invest in now that even white-collar jobs are vulnerable to offshoring? How can you protect the value of your education credentials?) -Friends, families, and neighborhoods/communities are social capital (the family as a nexus of contracts; Are friendships investments?; Houses as assets whose property values need to be protected, not as membership in a community) -The bursting of the housing bubble put an end to the idea that homeowners were socially tied to communities (In a portfolio society, a house is just another kind of asset) -The portfolio society is a uniquely American invention (Japan still embraces lifetime employment and openly rejects shareholder-value conceptions of the corporation; German corporations are mostly privately held, and investment is organized by banks, not financial markets

The Economic Theory of Action (two key components: Self-Interest and Rationality)

-Individuals act in their own self-interest -Individuals act rationally, engaging in "maximizing" behavior: Maximizing their incomes, profits, or "utility" (well-being) -Action is also deliberate and calculated: Individuals elaborate a series of choices, calculate which choices will maximize their objectives, and choose to act based on those calculations -Economic Sociology Approach: However, this rational, maximizing behavior looks different in different contexts (e.g., bond traders vs. stock traders); Cognition is shaped by institutional context

Halo Effect

-Investment banks rely on the halo effect of elite universities -Elite educational institutions play a key role in labor-market status hierarchies that the jobs chosen by their students are, by definition, the most prestigious

Why are mortgage bonds and CDO's safer than the individual mortgages they contain, and what is the key assumption that must be true for them to be safer? (Hint: How are bonds and CDO's like insurance?)

-Key Assumption: Housing prices always go up -The idea of pooling risk into mortgage bonds meant that investors had a new way to protect themselves against mortgage default, even if the loans weren't backed by the government -As long as you can accurately predict the probability of default by each borrower, then you can pool the risk -CDO's: Take a bunch of mortgage bonds (or other CDO's), slice them up, and repackage them together to pool the risk -Corporate bonds had no risk of prepayment, so CDO's were aimed at pooling the risk of default -Diversification was the main justification for creating both mortgage bonds and CDO's (Pooling lost of mortgages eliminates idiosyncratic risk and leaves only systematic risk)

Explain Keynes's famous statement: "The market can stay irrational longer than you can stay solvent"

-Keynes lost $13,000 on an investment he assumed would earn him $14,000, because the market acted perversely in the short-term -From this quote, Keynes means that the market can switch on you at any moment, and you have to be prepared for that to happen -Investors can't focus on the intrinsic value of assets but must instead focus on what everyone else thinks the asset is worth (its price, not its value) -Keynesian Beauty Contest

Tacit Knowledge

-Knowledge that can only be learned through experience; it is difficult to write down or teach merely by explaining (memorizing chess positions, work-to-rule strike) -Example: Pit trading is often viewed as a skill that can only be acquired through years of experience; no one can just walk onto the trading floor and make millions without experience -Example: Ethnographic studies provide researchers with a personal experience that they can use to justify an argument

Legitimacy

-Lawfulness or credibility associated with something; typically a security or financial practice -The threat of being denied legitimacy forces organizations to conform to norms -Moral Bifurcation: Activities can be deemed wholly illegitimate at first, but defenders can then try to split the debate by arguing that there are both good and bad forms of the new activity; if that succeeds, there is no more debate about whether the new activity itself is okay; it's instead about the particular uses (this is how HFT became legitimated) -Example: Legitimacy of corporate practices shifted with the institution of managerial capitalism over finance capitalism (Under finance capitalism, corporations had cynically implemented employee benefits to improve public opinion; Under managerialism, corporate leaders saw themselves as responsible for the social welfare of their employees, their communities, and broader society) -Example: Black-Scholes-Merton model for options pricing gave legitimacy to options trading once projections and prices observed in reality converged for a seven-year period prior to the Stock Market Crash of 1987 -Example: Legitimacy of corporate practices shifted with the institution of shareholder value over managerial capitalism (Under managerialism, companies are social institutions who have a duty to look after their workers, customers, communities, and society more generally; Under shareholder value, companies maximize social welfare by maximizing share price) -Example: With the increasing popularity of CDO's prior to the 2008 Financial Crisis, practices spread through legitimacy (firms embrace things that are popular with others) and through vicarious learning (firms embrace things that look like they're successful for others; mimetic isomorphism: organizations copy each other) -Example: In the early 1970s, options were stigmatized as mere speculation or gambling (Derivatives had been prohibited by law unless they could result in the physical delivery of some good); Leo Melamed asked Milton Friedman to write a paper on the need for currency derivatives, given the looming Bretton Woods crisis, which gave legitimacy to the possibility of opening an options exchange -Example: Similar to Melamed having Friedman write him a paper to legitimate the institution of currency derivatives, the CBOT commissioned a group of MIT and Princeton economists to write a report supporting the need for a market in stock options, and they succeeded in lobbying the SEC to allow them to open an options exchange (getting smart college students to write this report legitimized an options exchange)

Leverage

-Leverage: Ratio of borrowed money to actual assets held -Higher leverage means that you have to put up smaller amounts of money for the same size investment -Leverage amplifies both gains and losses: You can gamble on much bigger bets than you actually have money to support -2004: SEC relaxes capital requirements on largest investment banks, allowing them to become more highly leveraged -All the big investment banks boosted their leverage to more than 30:1 (except Goldman Sachs, who stayed around 25:1) -Bear Stearns and Lehman Brothers were the most highly leveraged investment banks -Because banks were so highly leveraged, losses were multiplied well beyond what they could cover with their own capital -Banks had many tools to protect themselves from the crisis in the short-term, such as Creative Accounting: At the end of each quarter, Lehman Brothers would temporarily exchange $50 billion in assets for cash, publish its financial report, then get the $50 billion in assets back (this hid how highly leveraged they were, and it obscured their losses; Lehman Brothers was later charged for doing this, but the SEC determined that this had ultimately been legal)

Why are racial minorities more successful in product-side jobs than in relationship-side jobs?

-Like women, racial minorities are funneled towards particular Wall Street sectors, specifically "Product-Side" (analysis) ares vs. "Relationship-Side" (deal origination and client management) areas -In many cases, the relationship-side departments are higher in status, since they bring in the deals -Relationship-side areas depend heavily on workers' individual cultural capital for success, which puts racial minorities at a disadvantage -Product-side areas are more focused on technical skills, and they are seen as more meritocratic, so they are often the only jobs open to racial minorities -Asians are stereotyped as quantitative and technical and are pushed into product-side roles -Racial minorities are socialized to avoid each other ("Class Slippage") -Racial minorities are often excluded from the social side of rewards; This feeds back into disadvantage at work, since so much networking happens among elites outside the job

How did the hostile-takeover movement succeed in creating a market for corporate control?

-Low stock prices create incentives for outsiders to buy control of the company and improve its management -Control of a company is an "asset" that can be bought and solf -Barriers to an active takeover market (prior to the 1980's): (1) Corporate size (Growth of corporations over the 20th century meant that many of them were so big that it was difficult to buy corporate control) and (2) Antitrust law (Federal enforcement of antitrust laws was largely abandoned in the 1980's to encourage the takeover movement) -The takeover wave of the 1980's is what launched (1) executive compensation being tied to stock prices, (2) board independence, and (3) outside monitoring; As a result, a market for corporate control was created -The takeover wave gave ownership and power to proponents of shareholder value, allowing them to implement new corporate practices

Managerialism (i.e., managerial capitalism)

-Managerial Capitalism (1920's-1970's): Managers took power, with little accountability to stockholders -Supporters of Managerialism: Workers, customers, communities, the environment -Under Managerialism, companies are social institutions who have a duty to look after their workers, customers, communities, and society more generally -Managers rarely had ownership stakes in corporations -Managers themselves typically elected boards of directors -Managerialism provided an internal labor market (path for promotion), a plethora of "entry-level" jobs, job security, defined-benefit pension plans for retirement, and health care -World War II U.S. productivity cemented Managerialism as a huge "success" -Industrial corporations became the dominant players in American society, organizing people's lives both at and away from work -Under Managerialism, corporate leaders saw themselves as responsible for the social welfare of their employees, their communities, and broader society (share price acted as a "report card" for managers) -Corporations are seen as providers of lifetime employment, pensions, health care, etc. (The Organization Man: Moral justification for corporate behaviors) -Shareholders have no real property rights in a corporation, just a claim on a dividend stream (Control only comes if you buy a majority share) -Shareholders sometimes have voting rights, but most votes are for resolutions that are merely advisory -Under Managerialism, there were no takeovers, CEO's were rarely fired, and manager compensation was unlinked to stock price or profits -Principal-Agent Problem that arose under Managerialism: How do you convince managers to act in the interests of the owners instead of in their own interests?

Market Power

-Market power refers to a company's relative ability to manipulate the price of an item in the marketplace by manipulating the level of supply, demand or both (Market power = big profits) -When you have the ability to manipulate the price of an item through the market power you have, you also have the ability to control the profit margin of the item -Financial markets try to use standardization to prevent sellers from gaining market power -One way to create market power is through product differentiation -Example: During the hostile takeover movement, takeover firms exercised market power to buy and break up conglomerates and fire executives (threat alone was enough) -Example: Market power (and cartels) are another example of social closure -Example: Labor markets aren't perfectly competitive, and there are typically certain groups/actors that can exercise market power

Why is it so hard to bet against the housing market (and the housing bubble), and how did traders solve this problem in the mid-2000's?

-Most people still wanted to bet on the housing market, because prices always went up (key assumption) -A Credit Default Swap (CDS) provides a way to bet against mortgage bonds (short the market) How do you short the housing market as a whole? -You can try shorting the stocks of companies involved in the market: Mortgage lenders, construction companies, etc. -But if stock prices kept rising for longer than you can put up the margin, your bet might end before it pays off, even if you're right in the long-run -If prices rose very high very quickly, your losses could be unlimited You could short asset-backed bonds (such as mortgage bonds) -Problem: Unlike stocks, which are easy to borrow, each mortgage bond represents a unique pool of mortgages, so it's impossible to borrow against a specific bond -You can't sell them short, so you have two choices: Either you like mortgage bonds or you love them CDO's -Problem: Many institutional investors could only buy AAA-rated bonds (equivalent in risk to federal treasury bills) or sometimes AA-rated bonds (the second-least-riskiest category) -Now that mortgage bonds contained so many subprime mortgages held by people with bad credit, those bonds received lower ratings (many of them junk status)

Why did electronic markets start paying brokers to trade on their exchanges, and what were the consequences of this?

-One bizarre consequence of HFT is that many exchanges like BATS started paying brokers to bring their trades to the market (Rebate Arbitrage), rather than charging them a fee to execute trades (this creates a conflict of interest for brokers, because they want to collect fees, even if it means hurting their customers) -HFT enabled rebate arbitrage because exchanges sold speed to HFT firms, but HFT would only pay if there was a large stream of orders from which they could profit -In theory, payments for trading were meant to encourage liquidity -HFT firms figured out how to get paid for trading without actually providing any liquidity (HFT provides liquidity on "thick" orders but not on "thin" orders—they only provide liquidity where it isn't needed)

What does it mean to say that markets are socially constructed institutions? (This is a key unifying idea of the course)

-People ("Actors") behave within networks and institutions that the people themselves continuously create (and re-create) -Through interaction, people construct norms, scripts, and strategies that guide their future behavior -Market making is different on the NYSE, the CBOT, and in bond markets, because market makes are "embedded" in different social contexts -Rational maximizing is interpreted differently on these different markets

Performativity

-Performativity: Using some aspect of economics to guide your behavior in a market eventually makes that market look more like the way economics depicts it -Using the Black-Scholes-Merton model of options pricing to trade options eventually caused market prices to fit the model -Not any model could've done what the Black-Scholes-Merton model did; there had to be some underlying aspect of the model that corresponds to real financial markets for it to work -The Black-Scholes-Merton model came before the market: It dictated the specific path the market would follow, and it enabled the market to grow (similar to how the evolution of futures markets relied on the emergence of grain elevators, options trading relied on the emergence of new technologies, such as economic models, to set the path for market development) -Early 1970's: Options prices based on the Black-Scholes-Merton model didn't really match options prices observed in reality (out in markets) -Mid 1970's: Adoption of Black-Scholes-Merton by traders increases (pricing sheets used by traders to calculate prices; Spreading arbitrage diffused widely: Volatility was priced equally for all options on the same underlying stock/asset) -Early 1980's: Market prices for options now matched prices based on the Black-Scholes-Merton model (using the Black-Scholes-Merton model of options pricing to trade options eventually caused market prices to fit the model; in MacKenzie's terms, the options market "performs" the model--reality begins to match economic theory) -Performativity emphasizes that it's not just beliefs, and the beliefs don't have to be false (Self-Fulfilling Prophecy) -Essentially, Black-Scholes-Merton remade the world in its own image -Adoption and use of the Black-Scholes-Merton model "affected" prices; the model didn't merely describe reality -The model was an engine (actively driving prices), not just a camera (reflecting what was out in the world)

According to Fligstein, Brundage, and Schultz, how did framing and positive asymmetry cause the Federal Reserve to fail to anticipate the financial crisis?

-Positive Asymmetry: You clearly see clearly best-case scenarios, but you distort worst-case scenarios (making them more positive); ignoring the work case isn't just a psychological trait, it's supported by organization practices and routines -The structure and culture of most organizations leads people within them to downplay negative information or to reinterpret it in a positive light -The FOMC exhibited positive asymmetry, interpreting dangerous economic signs as normal -Frames: The set of cognitive assumptions, categories, and tools that someone uses to understand something in the world -Different groups have different cognitive frames (e.g., two key frames used by the Federal Reserve: Macroeconomics frame vs. "finance and banking" frame) -Frames: "Principles of organization which govern subjective meanings we assign to social events" (Goffman) -Frames make some interpretations of events likely and other interpretations less likely (Frames shape how we filter information--what do we pay attention to and what do we ignore?); compare the "prepayment risk" vs. "default risk" frames we saw inside ratings agencies (MacKenzie) -Bounded Rationality means that our brains can't possibly have complete information (we can't look at absolutely everything) -Frames help filter out all the information we deem as unnecessary, but they consequently create blind spots in the process -Frames enable consensus within groups (they're useful) -The professional backgrounds of FOMC members shapes their frames: Professional bankers were more likely to adopt a finance and banking frame, while economists whose research focused on macroeconomics adopt the macroeconomics frame -FOMC was dominated by a set of macroeconomists who all had the same frame, particularly the new neoclassical synthesis -FOMC members with a macroeconomics frame discounted the possibility that financial markets can have real impacts on the broader economy -The macroeconomic frame caused the FOMC to ignore the importance of financial markets and to treat any signs of danger as self-correcting -It's hard to have a diversity of frames while still allowing consensus to form, and the FOMC is historically based on consensus -FOMC members with finance/banking backgrounds were more attuned to crisis, but macroeconomists still have most of the power within the Federal Reserve

Power

-Power is the ability to shape how others view the world along with their interests -People rarely "see" power operating because ideology makes many conventions seem natural and inevitable. -An example of power being used in this sense occurred in 19th century Britain, when wealthy industrialists convinced political leaders that cartels were an efficient way to organize industry. In this instance, power is clearly being used in a way that's motivated by the self-interest of the wealthy industrialists who want greater profits

Electronic Front-Running

-Practice by market makers of dealing on advance information provided by their brokers and investment analysts, before their clients have been given the information -Electronic Front-Running Process: -(1) Watch what an investor does in one market, then beat the investor to the other markets -(2) HFTer puts up tons of minimum-size (100 shares) orders on every stock on the market, typically at the low end of the current spread -(3) New orders snap up their 100-share offers first, which tells the HFTer there's a bigger order out there -(4) HFT firms even use "latency tables" to identify what firm an order is coming from, which allows them to predict order size -(5) HFT then buys the cheap options on other markets, bids up the price, then pockets the difference between the original order price and the new market price -(6) All this happens before the investor's order arrives at the next exchange (traders like Brad Katsuyama started noticing that the market they saw on their screens wasn't actually the market) -HFTers used electronic front-running for arbitrage opportunities (Front-running was a form of power being acted on the markets by HFTers) -In 2004, more than 20 specialists on the NYSE were accused of "front-running" their customers; (1) Specialists saw orders before they were public, because they were the ones executing the trades; (2) Specialists could use this information to bid up the price of the stock before they executed the order and then profit from the difference -Fear of front-running led to new market rules: Reg NMS, which required brokers to execute orders at the "best price" (replacing an older, vague standard of "best execution") -Reg NMS set up the National Best Bid and Offer (NBBO) system, which defined what the "best price" was; NBBO was implemented via the Securities Information Processor (SIP), which aggregated prices from every different stock exchange to determine the current market price -Reg NMS was designed to create equality of opportunity in the market and prevent front-running; instead, Reg NMS changed the landscape in a way that gave big advantages to traders who could operate more quickly

Ratings Reactivity (Espeland and Sauder)

-Ratings Reactivity: Builders of mortgage bonds adjusted them to fit whatever criteria the ratings agencies needed to justify the rating the builders needed -Banks knew what ratings-spread target it had to hit to create a competitive/profitable product, and they designed them to hit specific ratings targets (Rating Reactivity)

What does it mean to say that laws and regulations are necessary to create free markets?

-Regulation can both support and inhibit market efficiency; its effects aren't uniform -Futures markets are a site of "free" competition, which is a carefully organized, artificial social arrangement -Regulation is a rule or law designed to control the behavior of those to whom it applies; those who fail to follow these rules are subject to fines and imprisonment and could have their property or businesses seized -With so much opportunistic behavior around the economy, laws and regulation prevent people from taking advantage of free markets

How did shareholder value inadvertently encourage accounting fraud?

-Securities analysts began creating projections of profits and losses, making firms no longer believe they needed to be profitable -Now, firms needed to simply meet (or exceed) analysts' expectations (projections); Shift from "maximize profits" to "beat the analysts" -The need for corporations to hit earnings targets set by analysts and institutional investors encouraged corporations to lie about their earnings -Goal: Make it look like earnings will rise steadily at a constant rate... forever -In bad years, they overstated earnings, and in good years, they understated them (to stash money for a "rainy day"), all with the help of big accounting firms -If you think about the incentives of corporate managers, this consequence should've been obvious -If executives are being paid based on stock price, and stock price is tied directly to profits, then executives have strong incentives to lie about profits

Arbitrage (Classical)

-Simultaneous buying and selling of an asset in different markets to gain risk-free profit from price differences (guaranteed profit) -Arbitrage as association exposes traders to real risks and losses; doesn't have guaranteed profit like classical arbitrage -Just like arbitrage as association, classical arbitrage is also based on comparisons between two particular assets that are related in some way (the two assets must be similar enough that the trader can predict how their prices will change in relation to each other but different enough that other traders haven't yet discovered this relationship) -Textbook descriptions of arbitrage--and even Zuckerman's more complicated story--take for granted that arbitrage opportunities are obvious to recognize and easy to trade on (difficult social and intellectual work must happen to pull off successful arbitrage trades in modern markets)

Path Dependence

-Small (or even accidental) decisions and events can persist and grow over time, "locking in" their effects (e.g., QWERTY keyboard) -Prepayment risk in early mortgage evaluation remained the key worry even after subprime mortgages came into being -It's easier to modify an existing practice than to develop a new one (ABS CDO rating system)

Social Capital

-Social capital: Refers to the resources available to an individual based on their social network -Elite parents' social connections open doors for their children -Students' social networks also create opportunities (social networks shape student aspirations, promote shared learning, and provide information about college admissions and (later) career opportunities)

Bounded Rationality

-Sociologists, psychologists, and (more recently) behavioral economists point out that people have cognitive limitations that constrain one's ability to interpret, process, and act on information -People don't have fully ordered preferences—they often figure out what they like as they go along -People have limited "calculating" power (Brains are limited in how much information they can process; Rational calculation is often replaced by heuristics and biases) -People don't behave as perfect rational maximizers -This connects back to institutions and the need to constantly re-create them: People can't store that much information -Example: Frames make some interpretations of events likely and other interpretations less likely (Bounded rationality means that our brains can't possibly have complete information)

Standardization (e.g., financial instruments, grain)

-Standardization: A framework of agreements to which all relevant parties in an industry or organization must adhere to ensure that all processes associated with the creation of a good or bad performance of a service are performed within set guidelines -Financial markets try to use standardization to prevent sellers from gaining market power -Example: The CBOT used its new power to standardize grain in Chicago, designating three categories of wheat (white winter, red winter, and spring); however, the CBOT wasn't doing this to solve the problem of sacks -Example: Standardization made futures markets possible, but it also made corners possible (Standardized quality grades subdivided the overall supply of wheat, making it feasible for a group to buy up a large portion of the market supply in a particular grade; wheat of one grade can't be used to fulfill a contract for another grade; without grades the wheat supply is too large to feasibly corner) -Standardization often means simplification aimed at a particular goal (simplification means that some things get left out) -Instrumental Rationality (Weber): Focusing narrowly on the means used to accomplish some goal, not on the goals (ends) themselves

Social Closure

-Status provides one mechanism for social closure (Market power (and cartels) are another example of social closure) -Example: Elite networks lock everyone else out of most prestigious jobs

For what purposes are stocks primarily used? (Hint: They're almost never used to raise capital for the corporation issuing the stock)

-Stock: A piece of ownership; a claim on future income/profits -Stocks are rarely used to raise capital for investment -Stock allows founder/owners to transfer ownership (and cash out) -Stocks are speculative investments (investors hoping the price increases) and an income stream (dividends) -When you buy stock, the money goes to other owners, not to the company itself (corporations typically get money for investment through credit) -Shareholder value has turned the stock market into a market for corporate control

Value-Price Arbitrage

-Taking advantage of the difference between the value of the company and its price on the market -Value investors (contrarians) like value-price arbitrage -Momentum traders (pure constructionists) don't utilize value-price arbitrage and typically follow other investors; don't worry about intrinsic value -EMH: Investors should engage in value-price arbitrage when prices don't seem to match underlying values (exploit the differences between an asset's price and its intrinsic value) -Pure Constructionism: Value-price arbitrage is too dangerous, because there's no guarantee the market will ever converge on value -Value Investing assumes arbitrage opportunities exist (contrary to EMH) and that markets will eventually converge on intrinsic value of the assets (contrary to pure constructionism): Trust your own judgement of value and buy or sell based on that, not based on the views of the speculative market -Value-price arbitrage: The price of an asset differs from its "true" value, and investors can (maybe?) profit from this difference

Regulatory Capture

-The "revolving door" between regulatory agencies and the industries/actors they regulate often creates "regulatory capture" -Regulatory agencies make decisions that benefit the people they regulate rather than benefitting the general public -Regulators cycle back and forth between government and industry -Incentives are aligned with industry, who pays their long-term salary: Individual regulators are rewarded with jobs and other monetary rewards -Network ties between regulators and industry create trust and enable favorable treatment -Example: After nine years at the SEC, the head of the Trading and Markets division, which regulates things like HFT, left for a job as general counsel at Citadel, one of the biggest HFT firms; he was immediately replaced by Brett Redfearn, head of market structure at JP Morgan, who might be more favorable toward IEX -This is a case where internal disagreement on Wall Street means that even a captured agency has different interests to serve

Explain the three crises that the state faced in the 1970's that set the stage for financialization (You should be able to explain each crisis in a sentence or two--not a lot of detail needed here)

-The declining economy of the 1970's ended the postwar expansion and created a series of crises for the state: (1) Social Crisis, (2) Fiscal Crisis, (3) Legitimation Crisis Social Crisis: -Following World War II, the state increasingly distributed wealth to all social groups in the economy, but economic slowdown required this to be scaled back; However, rising inflation diluted the cost of social expenditures and caused a self-reinforcing cycle of workers being upset with prices Fiscal Crisis: -Political pressure on the state to fund inputs to the economy (physical infrastructure, human capital, and demand for products) in the 1970's created expenditures too large to be paid by tax revenues; social unrest added to the demand for more state spending, which added further to inflation, and debt payment increased the strain on the state Legitimation Crisis: -Failure of the state to deliver on its spending commitments resulted in a loss of confidence in the state; furthermore, the state was blamed for any economic problem that arose when it tried to fix certain areas of the economy (government's goal was price stability, but inflation was viewed as a failure of the state; government's goal was full employment, but policy makers were at fault for unemployment)

Bid/Ask Spread

-The difference between the bid price and the asked price in electronic trading -Bids: Offers to buy -Asks: Offers to sell -Example: Astoria Financial (AF) selling at 7.74-7.75 -Bid: How much you can sell shares for (here, 7.74) -Ask: How much you can buy shares for (here, 7.75) -In the old market-maker days on the NYSE, for example, traders made money by pocketing the difference between bid and ask, i.e., "the spread" -In electronic "front-running", HFTers could buy cheap options on other markets, bid up the price, then pocket the difference between the original order price and the new market price -Electronic trading brought a huge number of new investors to the market, and that alone should've increased volume and narrowed the bid-ask spread -HFT proponents claim that HFT is responsible for smaller spreads (You might see smaller spreads on average out on the market, but most of that is due to flash orders or small orders from HFTers looking to gain information, but you can't actually fill your orders at those spreads)

Positive Asymmetry

-The structure and culture of most organizations leads people within them to downplay negative information or to reinterpret it in a positive light -Positive Asymmetry: You clearly see clearly best-case scenarios, but you distort worst-case scenarios (making them more positive); ignoring the work case isn't just a psychological trait, it's supported by organization practices and routines -The FOMC exhibited positive asymmetry, interpreting dangerous economic signs as normal

Mimetic Isomorphism

-The tendency of similar organizations to adopt the same kinds of rules and procedures in the belief that what works for one organization should work for others (organizations copy each other) -This differs from standard economic theories that each organization comes to a rational conclusion about what it should do, and firms look similar simply because they all reach the same conclusions

Commensuration

-To establish prices, goods must be Commensurable: they're similar enough that you can compare and rank them -Example: To turn qualities of wheat (plump, dry, heavy, clean, pure) into a common quantifiable metric, the CBOT (1) Appointed an official grain inspector to set standards, (2) got the grain inspector to personally train a committee of assistants in how to grade wheat, and (3) get the elevators to agree to allowing inspectors to enter warehouses to ensure that wheat in individual bins matched the quality they claimed for the wheat they were selling -Many "singular" goods create situations where commensuration is difficult: -(1) Products can be morally contested, and people aren't willing to price them (life insurance, bodily organs) -(2) Products can depend on aesthetic judgements for evaluation and pricing (art, fashion -(3) Sometimes the quality of a good's producer determines the price (status of investment bank) -(4) Value for one buyer can depend on the anticipation of its value to other buyers (houses to flip); Keynesian "Beauty Contest": People price stocks not based on what they think they're worth but rather by what they believe others' average assessment of average worth will be -(5) Products might have competing/incommensurable forms of evaluation (labor markets where firms look at each other for evaluation, ABS's vs. CDO's: Alternative evaluations of risk create price differences and arbitrage opportunities) -Example: Ratings allow commensuration; ratings make it possible to directly compare the riskiness of wildly different securities (pools of credit card loans vs. corporate bonds); ratings create a black box, where investors no longer need to look at what's inside securities--they just look at the stamped on them

Why is there a tradeoff between opportunism and restraint, and how do traders solve this problem?

-Traders want to make as much money as they can, but if there's too much cheating (opportunistic behavior), no one will want to do business with you -Tradeoff between short-term self-interest and long-run survival of the market -Market participants create "fair" competition by actively constructing and maintaining it (competition isn't a natural state)

Explain arbitrage as association/commensuration: How does it differ from classical arbitrage, and how do traders discover opportunities?

-Unlike classical arbitrage, arbitrage as association does not guarantee profits—traders are exposed to real risk and losses -Arbitrage as association relies on identifying different strategies of evaluation that do not match -Like classical arbitrage, arbitrage as association is based on comparisons between two particular assets that are related in some way (The two assets must be similar enough that the trader can predict how their prices will change in relation to each other but different enough that other traders have not yet discovered this relationship) -Traders discover arbitrage opportunities by making the trading room into a lab, run experiments, test the market -Arbitrage depends on both exploration and exploitation (innovation often comes from new associations, and interacting with different people produces these moments) -The trading room is designed to foster both exploration and exploitation -Innovative arbitrage opportunities are ultimately about experimenting with new ideas about the association between two things and seeing if the experiment "works" (i.e., it makes a profit) -Innovation (and the balancing of exploration vs. exploitation) challenges traditional views of cognition as calculative maximizing before one begins to act

What caused options prices to converge towards the predictions of the Black-Scholes-Merton model, at least until 1987?

-Using the Black-Scholes-Merton model of options pricing to trade options eventually caused market prices to fit the model -The cognitive simplicity of Black-Scholes-Merton, its public availability, and the idea of using paper price sheets made it possible for the model to gain a foothold on the trading floor, despite early skepticism -Because the spreading strategy had diffused widely, and it profited on the precise deviations Rubinstein was looking for, Rubinstein found remarkable convergence between the Black-Scholes-Merton model and actual options prices -The Black-Scholes-Merton model (and Black himself, through his promotion of spreading) encouraged particular trades that—coincidentally—formed the foundation of testing the theory -Securities regulations also caught up with the assumptions of the model, and that further brought prices in line with theory -In the early period of Black-Scholes-Merton, performativity brought reality in line with the model -The model was an engine (actively driving prices), not just a camera (reflecting what was out in the world)

Keynesian Beauty Contest

-Value for one buyer can depend on the anticipation of its value to other buyers (e.g., houses to flip, Keynesian beauty contest) -Keynesian "beauty contest": People price stocks not based on what they think they're worth but rather by what they believe others' average assessment of average worth will be -Pure constructionist perspective: Financial markets are a Keynesian beauty contest where prices have no relationship to intrinsic value (pick what you think is most likely to catch the fancy of others)

The corporation as a nexus-of-contracts

-Viewing the corporation as just a set of contracts—rather than as an institution responsible for its workers and others—means that there is nothing essential that unites different parts of a corporation -As a result of the hostile takeover movement, the corporation would be viewed as a nexus of contracts: Everything in a corporation can be split into pieces (if the value of all individual pieces of a corporation is greater than what the whole (intact) corporation is valued at, it was profitable to split it up and sell off the pieces) -If takeovers bring efficiency, and corporations are just sets of contracts, then we should open up the takeover market and break up the large, diversified conglomerates that had come to dominate society from the 1920's-1970's -Shareholder value provided an institutional rationale for breaking up conglomerates, and the corporation-as-nexus-of-contracts provided a new set of cognitive categories to make sense of corporations (the desire to break up the conglomerates unleashed a new wave of financial innovations that led to the hostile takeover movement of the 1980's and solidified the era of shareholder capitalism) -Against the corporation-as-social-institution model, financial economists argued that a corporation was simply a nexus of contracts

How do performance evaluations contribute to the gender pay gap? (i.e., Why are performance evaluations not objective?)

-Wall Street bonus system is based on individual performance evaluations -The same kinds of cultural, cognitive, and emotional processes that we saw in hiring also operate when managers (subjectively) rate worker performance -Bonus pay depends heavily on overall firm performance, and when firms perform poorly, they also rate individual employees poorly (across the board—without regard for gender) -At the individual level, performance evaluations aren't "objective" -Homophily (here, same gender) between managers and workers and among managers leads to better ratings (Castilla 2011) -Since men still outnumber women by a long way in the highest positions of power, this produces gender differences in wages -When people are told that firms have anti-discrimination policies (as on Wall Street), whites and men become blind to discrimination -Managers don't like being told whom to promote and pay well, and they can shape the performance evaluations to fit their own preferences

How did real, material structures enable opportunism and hyper-rationality in 1980's bond markets?

-What enables self-interest as opportunism in bond markets?: -(1) Huge short-term incentives to make money -(2) Asymmetric Information: Traders have private information about the state of the market and about their customers -(3) Limited informal controls: Weak social relationships among traders -(4) Limited formal (legal) controls: 1980's was a period of low enforcement of SEC rules -What enables hyper-rationality among bond traders?: -(1) Continuous flow of information -(2) High uncertainty (about prices, about the appearance of bids and offers) puts limits on prediction, which encourages vigilance (maximum accuracy) but also intuitive leaps in decisions -(3) High-stakes outcomes make deliberate, exhaustive calculation worthwhile -Bond traders have two strategies to behave in an economically rational way: -(1) Self-interest is enacted as "Opportunism" -(2) Rationality is enacted as "hyper-rationality" (Heavy use of analytics; "Vigilance": Ritualized habits and customs for gathering and processing information--trying to figure out how something is priced; Intuitive judgement) -Hyper-rational traders rely heavily on vigilance and analytics, yet most of their decisions are ultimately based on intuitive judgements -For bond traders, rationality provides a set of concepts and language to talk about why people make the decisions they do

Liquidity

-What is liquidity? There are always buyers and sellers out in the market that allow you to sell an asset quickly and its market price -Electronic markets promise greater liquidity by increasing the number of traders in the market (making the market global) -Pit traders say that Chicago markets are famous for providing liquidity, because the pit provides speculators (and market makers) who will always trade -Algorithmic trading can wipe out liquidity; Narrower bid/ask spreads under electronic trading limit the ability of market makers to make a profit -Liquidity describes the degree to which an asset or security can be quickly bought or sold in the market at a price reflecting its intrinsic value; in other words: the ease of converting it to cash -One bizarre consequence of HFT is that many exchanges like BATS started paying brokers to bring their trades to the market (Rebate Arbitrage), rather than charging them a fee to execute trades (in theory, payments for trading were meant to encourage liquidity) -HFT firms figured out how to get paid for trading without actually providing any liquidity (HFT provides liquidity on "thick" orders but not on "thin" orders—they only provide liquidity where it isn't needed) -Proponents of HFT argue that HFT increases liquidity, but Goldstein (2016) finds that HFT only provides liquidity in markets that already have it, and they take liquidity away from "thin" markets -When rain disrupts the HFT microwave network—and HFTers lose some of their speed advantage—we see improved liquidity and lower market volatility, and trading costs decline -Michael Lewis argues that liquidity is a useless term that's used to obscure rather than clarify—people use it as a synonym for volume, but if we value liquidity, it's not because of volume

The Illegitimacy Discount

-Why are organizations so similar to one another? -Certain practices and organizational forms become acceptable as legitimate, while others are deemed illegitimate -The threat of being denied legitimacy causes organizations to conform to norms -But who is responsible for deciding whether something is legitimate? -Many markets have third-party audiences that determine whether a product or practice is legitimate -Hypothesis: Products have weaker demand if they fail to attract reviews from the critics who specialize in the category in which the product is marketed -How do securities analysts shape whether particular organizations and product markets are legitimate?

Occupational sex segregation

-Women are sorted into female-dominated occupations like HR and administrative roles -Because these jobs are female-dominated, they're culturally devalued and pay less -If you look at changes over time in sex composition of different occupations, you find that pay increases dramatically as the proportion of male workers in an occupation rises -"Market logic" justifies this as meritocratic: Many firms determine wages in part by looking at wages in other firms in similar jobs, arguing that this aggregate view reflects the "market rate" for the work -But they're looking at other female-dominated jobs, so this is circular: Women's jobs pay less because women do them

Career funneling at elite universities

Career Funneling: Elite universities restrict, rather than expand, the career paths open to their students -Four mechanisms for funneling: -(1) Lack of information when entering college: Incoming students lack information about all the possible career paths open to them (high expectations and motivation but little concrete direction); lack of information means that campus influences can have big effects (fellow students, student organizations, career-planning offices); students learn a ton about careers they never imagined being interested in -(2) On-campus recruiting: Recruiting fuels competition for prestigious jobs (particularly at elite colleges, investment banks and consulting firms host lavish receptions and have elaborate multi-stage interviews that demonstrate the competition and its rewards); finance and consulting dominate recruitment at Harvard (Career Center hosts large numbers of events devoted to applying to finance and consulting jobs; far fewer resources are available for other careers) -(3) Social expectations and insecurities about prestige: Elite students feel they must live up to expectations by landing elite jobs (because everyone agrees that Wall Street jobs are prestigious and getting such a job signals a student's individual worth and success); elite jobs are seen as "safe" (Wall Street jobs offer graduates a few years to build wealth, while they hope to later transition to other careers) -(4): Status boundaries between good jobs and ordinary jobs: Students learn to distinguish between high-status and "ordinary" jobs (high-status jobs require degrees from elite universities, high-status jobs recruit on campus, and high-status jobs have characteristics similar to the most highly visible jobs like finance or consulting)

How does economic and social capital give children of wealthy parents an advantage in school/college success?

Economic Capital: -Access to better primary and secondary schools (property-tax-based school funding and private schools) -Access to better resources and activities that elite schools value (test prep, AP courses, college counseling, extracurriculars) -College affordability (and information about affordability): Wealthier students choose colleges based on non-economic factors -Parental financial support during college (students less likely to work) Social Capital: -Elite parents' social connections open doors for their children -Students' social networks also create opportunities (Shape student aspirations; Promote shared learning; Provide information about college admissions and later career opportunities)

Opportunism

Opportunism: Lying, cheating, stealing (traders want to make as much money as they can, but if there's too much cheating, no one will want to do business with you; tradeoff between short-term self-interest and long-run survival of the market) -Self-interest is enacted as opportunism -Markets try to restrain opportunism, and therefore they try to restrain actions based on self-interest -Agent Opportunism ("Front-Running"): Use information that you gain as your customer's agent against them (When you know your customer is going to place an order, you go and buy the bonds first, driving up the price, and sell them to your customer at the higher price) -Insider Opportunism (Insider Trading): Using non-public information about a bond issuer (e.g., you know it's about to fail) to trade for a profit; both illegal and condemned by traders -Prediction: We should see more opportunism when there are weaker social ties around to generate trust -What determines the level of opportunism in a market? -(1) Strong reputational networks: Coupled with local norms, enforce behaviors -(2) Power among stakeholders: Powerful actors create conditions that allow them to exercise their own opportunism, and powerful actors try to restrain opportunism -(3) Institutionalized rules: Formal (legal) and informal rules and norms restrain or enable opportunism -(4) External power: Potential and actual regulatory intervention shapes behavior -(5) Cultural interpretations of opportunism and restraint (norms and cognition): People in different markets and at different levels (traders, exchange officials, regulators, customers) have different ideas of what constitutes acceptable behavior -How does opportunism survive in the bond market? -(1) No face-to-face relationships (the bond market is over-the-counter, so trades happen through computers or over the phone, often through intermediaries; this reinforces a weak reputational network) -(2) Traders are separated from their customers by the sales force (traders may feel bound to one another, but they feel little obligation to either salespeople or to their customers) -(3) The most opportunistic firms often provide the most profits, so customers accept some degree of opportunism -(4) Traders believe that customers expect them to be opportunistic, but customers can't predict which trades they'll get cheated on -What enables self-interest as opportunism in bond markets? (1) Huge short-term incentives to make money (2) Asymmetric Information: Traders have private information about the state of the market and about their customers (3) Limited Informal Controls: Weak social relationships among traders (4) Limited Formal (Legal) Controls: 1980's were a period of low enforcement of SEC rules Example: Early on, individual grain elevators set their own quality standards but had no reliable way to grade quality, which opened the door to opportunism; farmers would bring dirty, damp, mixed wheat to elevators

Contrast the moral rationales used by proponents of managerialism with those used by proponents of shareholder value

Shareholder Value (Shareholders, Managers, Analysts, Banks, Traders, Corporate Raiders): -If share price provides the best estimate of future profits (according to EMH), then companies maximize social welfare by maximizing their share price -EMH is a critical for others to be convinced of the moral rationale behind shareholder value -"Maximizing social welfare" has a very specific economic interpretation that means we have an "efficient" allocation of goods across the economy -"A rising tide lifts all boats" -Profit is the "excess" value created by a company after it pays off its contracts (with suppliers, employees, debt-holders); if shareholder price provides the best estimate of future profits according to the EMH, then companies maximize social welfare by maximizing their share price Managerialism (Workers, Customers, Communities, Environment): -Companies are social institutions who have a duty to look after their workers, customers, communities, and society more generally -The cognitive schema used to understand conglomerates (the corporation as a portfolio of businesses) was replaced by the concept of a firm as a nexus-of-contacts under shareholder value

Who are the winners and losers in high-frequency trading, and how does each one make or lose money?

Winners: -HFT firms -Big brokers who sell access to their orders and to their dark pools and who run their own proprietary trading desks -Electronic exchanges paid by HFT firms for access to speed (Spread Networks) Losers: -"Ordinary" investors: People trading stocks through retail accounts -Many kinds of institutional investors like mutual funds, who depend on brokers to execute their orders